Posted: Wed 16th Mar 2022
This guide is sponsored by PensionBee.
There are now around 4.2 million self-employed workers in the UK, from freelance writers and solo business owners to business consultants and self-employed construction workers. Together, they contribute an estimated £303 billion to the UK economy per year.
However, the percentage of self-employed workers who actively save into a pension has fallen steadily over the past decade. It now stands at under 25%.
This means that a significant number of self-employed people could struggle to make ends meet during retirement and may be forced to work for longer, if their health and personal circumstances allow it.
Like many people in self-employment, you may be reluctant to start a pension because you don't know enough about them and how they work. This six-part guide provides the clear and simple information you need to start saving and help keep your pension on track.
What is a pension? How do pensions work?
A pension is a fund you pay into over the course of your working life and then use to support yourself when you retire. As you work and make money, you pay some of what you earn into the pension, so your money has a chance to grow over time.
When you pay into a fund managed by a pension provider, the money is typically invested in shares, bonds or other types of investment (cash or property, for example). The size of the pension pot you're left with when you retire depends on how well these investments perform over time.
In the UK, there are three main kinds of pension.
The State Pension, the government pension you can claim when you reach State Pension age
A personal pension, which you set up with a pension provider yourself
A workplace pension, which you have if you work for an employer
As someone who's self-employed, the State Pension and a personal pension are the two you're likely to be eligible for, so we'll look at those in more detail.
What is the State Pension?
The State Pension is a regular payment you can claim from the government once you reach State Pension age.
The system has changed in recent years, so there's now a basic State Pension and a new State Pension. Which one you're entitled to depends on when you were born.
If you're a man born on or after 6 April 1951 or a woman born on or after 6 April 1953, you'll receive the new State Pension. If you were born before these dates (whatever your gender), you'll get the basic State Pension instead.
When will I get my State Pension?
You can't claim State Pension until you've reached State Pension age. For the new State Pension, this is currently 66, rising to 67 by 2028 and 68 between 2037 and 2039.
Although many people choose to claim their State Pension as soon as they reach State Pension age, you can also choose to delay claiming it. Doing so can increase the amount you receive each subsequent year.
How much pension will I get?
The amount you receive in State Pension depends on the National Insurance (NI) contributions you've paid during your working life. When you're self-employed, you pay these through the self-assessment system.
As you pay NI contributions, you accrue National Insurance Credits. The more you contribute, the more credits you make. When the time comes for you to claim State Pension, the government uses your credit total to determine how much you get in pension payments.
You need to have earned at least 10 years of National Insurance Credits by the time you retire to be eligible for State Pension.
How much is State Pension? Is it enough to live on?
At the time of writing, you can receive the full State Pension amount only if you have at least 35 years of National Insurance Credits. For 2022/2023, this maximum amount is £185.15 a week or £9,627.80 a year.
This isn't very much to live on, and keep in mind that – depending on your NI contributions – you may actually receive much less than this.
Also, as governments over the next few years try to find ways to cope with stretched budgets and longer life expectancies, the State Pension may be squeezed further. There's no guarantee of what tomorrow's pensioners will actually receive when they retire.
What is a personal pension?
A personal pension (also called a private pension) is one you set up yourself with a pension provider – like PensionBee, for example. It's up to you how much you'll pay in.
The pension provider manages your pension by investing it in a mixture of things like shares, bonds, property and cash. It also usually claims basic-rate tax relief on your behalf and adds it to your pot.
Most new personal pensions are defined contribution pensions. This means the amount you receive when you retire depends on how much you've paid in over time and how well your investments have performed.
After the age of 55 (increasing to 57 in 2028), you can either:
use your defined contribution pension to buy an annuity, which will then pay you an income for a fixed period or the rest of your life
take out your money bit by bit (though you will pay some tax)
take out a lump sum, and leave the rest invested until you decide to take out more in the future
How does a pension benefit me if I'm self-employed?
Unless you build up a decent pension pot while you're working, you're unlikely to be able to retire with a comfortable income. The average life expectancy in the UK is now over 80, so many people who work until their mid-60s will spend over a decade in retirement.
When you're self-employed, you're not benefiting from a workplace pension. With these pensions, your employer has a legal responsibility to enrol you in a pension scheme (called auto-enrolment). It must also make minimum contributions to this pension, as must you. On top of that, the government also contributes to your pension in the form of tax relief.
Without those savings, you might struggle to support yourself when you retire. Setting up a personal pension can be a good way of making sure you have financial security as soon as you stop working and earning money.
What is tax relief on pensions?
A major advantage of saving into a pension is the tax breaks you receive. The government encourages pension saving by providing tax relief on any personal contributions you make.
If you're a basic-rate taxpayer (that is, you earn between £12,571 and £50,270), you automatically get a 25% tax top-up. So, if you pay £100 into your pension, the government adds £25, bringing the total contribution to £125.
If you're a higher-rate taxpayer (you earn between £50,271 and £150,000) or an additional-rate taxpayer (you earn over £150,000), you can claim further tax relief via your self-assessment tax return.
There's no cap on the amount of money you can save into a personal pension each year. However, there is a limit on how much is tax-free. For 2022/23, this is 100% of your salary or £40,000 (whichever is lower).
Tax relief as the director of a limited company
If you've set up your business as a limited company, as company director you can make employer contributions into your pension. Since pension contributions count as an allowable expense, you can deduct them when you're working out your business's taxable profits.
You don't pay National Insurance on pension contributions either, so you could save a total of 33.8% tax when you pay money from your company into your pension.
What is a Nest pension?
The government created the National Employment Savings Trust (Nest) to allow employers that didn't have a workplace pension scheme to enrol their workers in a low-cost government pension plan.
When first set up, it wasn't available to people who were self-employed, but it is now. You can only invest £4,700 per year, but there's no rule to say you can't also set up a personal pension as well and be able to invest up to the annual allowance of £40,000 per year.
Pros and cons of setting up a Nest pension
One major advantage is that Nest is government-backed, meaning your money is well protected. The scheme also carries a low yearly management charge, so you pay less than other schemes to have your money looked after.
Some drawbacks, however, are that the investment choices and retirement options can be quite limited. The scheme has also received some criticism for its standard of customer service.
So, before you commit to anything, make sure you understand what the scheme is offering and that it meets your needs.
Why you should start a pension sooner rather than later!
However sensible it sounds to save into a pension, it's an easy thing to put off. But starting sooner could make a big difference to your pension pot when you retire. Compounding returns is the growth you earn on your pension's growth, and can turn a small savings pot into a significant amount when left untouched.
For example, if you start saving when you're 30 and contribute 15% of your £30,000 annual income from self-employment, you could end up with a pot worth £196,100 at retirement. If you don’t start saving until you’re 45 years old, saving at the same rate may only give you £109,500 when you reach retirement.*
The earlier you start saving, the more opportunity your pension will have to grow, and the less you'll need to save each month compared to starting later.
Capital at risk.
*These figures are intended for illustration only. As with all investments, capital is at risk and the value can go down as well as up. We have assumed a retirement age of 65, that your plan earns a 5% return before the effects of inflation and have taken inflation of 2.5% into account.
In part 2 of this guide, we look at how to set up a pension when you're self-employed.
Read the other parts in this series: